Poor rating could trigger lawsuits worldwide

Ratings agencies worldwide could be sued by investors who lost money during the global financial crisis after the Federal Court ruled yesterday (5 November) that Standard & Poor’s AAA rating of complex financial products was “misleading”.

In a landmark decision, the Federal Court slammed Standard & Poor’s for failing in its duty of care to investors by assigning a AAA rating to “grotesquely complicated” and risky synthetic derivatives known as constant proportion debt obligations (CPDOs).

Justice Jayne Jagot ruled in favour of 12 NSW local councils that lost millions on the failed investments in the aftermath of the GFC. She said a reasonably competent ratings agency could not have rated the product AAA.

Piper Alderman’s Amanda Banton (pictured), who represented the councils, argued that the volatility level assigned to the CPDOs was “clearly inappropriate”.

“The correct [volatility] figure should have been about 28 per cent and, if that correct figure was used, the product would not have received AAA rating,” she told Lawyers Weekly.

Consequently, the ratings methodology for CPDOs will be investigated and could prompt litigation against ratings agencies worldwide, said Banton, pointing out that the global value of CPDO products is estimated to be around $5 billion.

“That methodology has been found to be incorrect and we would assume ... having the benefit of our judgement there will be further litigation in respect of CPDOs.”

The 13 councils lost $16 million on the CPDOs, which were created by ABN Amro and assigned the AAA rating by Standard & Poor’s. When the GFC hit in 2007, the councils lost 93 per cent of the capital they invested in the CPDOs they bought from investment adviser Local Government Financial Services (LGFS). All three entities were found liable and ordered to pay an equal portion of the $30 million in damages.

The Court found that Standard & Poor’s was negligent as it owed a duty of care to investors, did not have reasonable grounds for assigning the AAA rating and could not rely on its disclaimers that the rating was merely opinion.

ABN Amro was found negligent for its involvement in procuring the rating, which included providing the low volatility assessment. Banton added that ABN Amro also engaged in misleading and deceptive conduct in passing on the unreliable rating because “it knew the rating was basically not true”.

“ABN Amro knew they were aiming for a particular rating and employed two former Standard & Poor’s employees so they could mine the rating and basically reverse engineer what they needed for the inputs to produce a AAA rating,” she explained.

The judge also deemed LGFS negligent for its failure to adequately disclose the material risks of the product to its clients – the councils.

Flawed methodology

Yesterday’s decision follows a ruling last month in the Federal Court that found the Australian arm of Lehman Brothers (now in liquidation) breached its legal duties when it sold toxic derivatives, known as collateralised debt obligations (CDOs), to a group of charities, councils and church groups that collectively lost around $250 million.

Like Lehman Brothers, LGFS was also found to have breached the fiduciary duty it owed to the councils as it had a financial conflict of interest with its clients. Banton explained that LGFS held the same CPDOs, called Rembrandt notes, on its own books and was profiting from the sale of the products.

“Both this and the Lehmans [decision] makes it clear that there’s an obligation on the product seller ... they can’t think they’re merely product sellers and don’t owe duties and obligations to the client.”

Banton is presently investigating the ratings methodology in CDOs (worth around $2 trillion worldwide), which were scrutinised in the Lehman Brothers case, and anticipates litigation involving these financial instruments because “the ratings methodology has the same flaws [as CPDOs]”.

IMF executive director, John Walker, claimed the ruling is the first judgment in the world in the wake of the GFC examining the conduct of a ratings agency concerning the rating of CDOs or CPDOs.

“We expect that investors, banks and regulatory authorities around the world will be examining this judgment carefully to determine the broader implications,” he said.

He added that IMF is exploring potential claims in the Netherlands in relation to CPDOs worth around €2 billion sold by ABN Amro and rated by Standard & Poor’s in Europe.

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